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Does High Frequency Trading Create Market Efficiency?
By Michael Schweibinz

High Frequency Trading (HFT) utilizes computer algorithms to move in and out of stock positions at extraordinarily high speeds. These algorithms identify market patterns and execute large volumes of security purchases and/or sales in milliseconds. Profits are generally counted in tenths of pennies per share; but it’s a volume business, and the pennies add up to big dollars.

Traders who utilize HFT programs gain a competitive advantage by having the most up-to-date information and the ability to execute faster trades. High frequency traders who have the most current prices can profit off other market participants who are trading based on stale prices. For the typical trader, the information disadvantage ranges anywhere from a matter of seconds to around 25 minutes—all depending on factors like their trading platform and proximity to the exchange.

The speed factor incentivizes high frequency traders to spare no expense in attempting to minimize price delay. Flash Boys, a new book by Michael Lewis, describes the construction of a fiber optics route from Chicago to New Jersey to route orders from CME to NYSE. This $300 million project knocked three milliseconds off the time for information to travel electronically from Chicago to New York. Seems a bit ridiculous, doesn’t it?

The SEC authorized electronic trading in 1989. Over the past decade, high frequency electronic trading has moved from being a little known topic within the financial sector, into a popular debate. It is estimated that HFT amounts to roughly 50% of daily stock market trading volume (down from its peak in 2009).

Many argue that HFT leads to more efficient markets, as it facilitates faster price discovery. But in reality, there may be little or no societal benefits to faster price discovery.

Former Goldman Sachs vice president, Wallace Turbeville, points out that “these trades are not designed to help businesses and governments raise money from pension funds, endowments or other sources of capital that could fund new, useful, productive projects. They are designed merely to generate profits from the process of the capital market.” Why is society “devoting an ever-growing share of its resources to financial wheeling and dealing, while getting little or nothing in return?”

High frequency traders don’t really compete with regular buy and hold investors; rather they generally compete with each other. However, as high frequency trading has boomed, the average person’s confidence in the stock markets has moved in the opposite direction. Consequently, some have proposed a “per share trading tax (an idea supported by First Affirmative), while others, such as Canada, have increased the fees charged to HFT firms.” Yet, due to the relative newness of HFT, the process of regulation has not come rapidly.

Nobel Prize winning economist, Joseph Stiglitz, presented his opinions on HFT to the Federal Reserve Bank earlier this year.

First Affirmative seeks to invest in companies that will do well for investors and make positive contributions to society at large. First Affirmative’s investment philosophy is generally based on long-term value creation. As such, HFT plays no role in First Affirmative’s business practice; but high frequency traders do affect stock prices on a daily basis—sometimes pushing prices a little higher; sometimes a little lower.

 

At First Affirmative, we understand that the ways we save, spend, and invest can dramatically influence both the fabric and consciousness of society. We believe that in addition to the benefits of ownership, investors bear responsibility for the impact our money has in the world. Are you making conscious decisions about the impact of your consumer purchase and investment decisions?

 

Mention of specific companies or securities should not be considered an endorsement or a recommendation to buy or sell that security. Past performance is no guarantee of future results.

 

Posted: May 28, 2014